A Guide to Inequality

Senator Bernie Sanders has now officially dropped out of the race and endorsed Hillary Clinton for President. Despite his loss, the achievement of his campaign should not be dismissed, especially his success with younger voters through populist rhetoric.  Speaking at the Vatican, Senator Sanders stated that “[A]s an increasing share of new wealth and income goes to a small fraction of those at the top, fixing this gross inequality has become a central challenge. The issue of wealth and income inequality is the great economic issue of our time, the great political issue of our time, and the great moral issue of our time.” However, as with any popular political movement, facts have been mixed with fiction, and even Sanders himself has been confused on what the data are showing.  Here are the facts.

Income Inequality. Income inequality looks at the uneven distribution of individual or household income across the earnings spectrum. How income is defined is extremely important, since several definitions are in use which will represent inequality in very different ways.  For example, market income is pre-tax income from market sources, while disposable income is income after taxes and transfers.

Many of the more wild claims about income inequality miss this distinction, treating all income the same way. For example, Bernie Sanders’ website directly states that he is using pre-tax income, but uses this as a justification to raise taxes, which would obviously be aimed at post-tax income inequality.  The change in pre-tax and post-tax income is rather considerable, especially considering that the top 1 percent already pay 43.6 percent of all federal income taxes.

To see just how big of a difference this makes, we can look at the Gini Index, a measurement of inequality where 0 represents perfectly equality and 1 represents perfect inequality.

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Source: Congressional Research Service

The United States pre-tax income Gini Index is 0.513, while its after-tax index is 0.396, a difference of 22.8 percent.

The United States has lower pre-tax income inequality than several OECD nations, but is still a bit higher than average.

The United States has a post-transfer change in equality than any other European nation but Turkey, meaning European nations are generally doing more to lower inequality.

In fact, when factoring in taxes and transfer programs (such as food stamps, Medicaid and cash assistance), the U.S. fiscal system is quite progressive as shown in a recent study from the NCPA by economists Laurence Kotlikoff, Alan Auerbach and Darryl Koehler. Considering all major federal and state tax and income transfer programs, Kotlikoff and his coauthors estimated lifetime net marginal tax rates and spending by age cohort. The results were surprising: Lower income households pay far fewer taxes as a share of their income than high-income households. In fact, low-income households actually have a negative net average lifetime tax rate — meaning they receive more in benefits over their lifetimes than they pay in taxes.

Consumption Inequality. An implicit assumption around many discussions on economic inequality is that the greater the wealth or income, the greater the standard of living.  While this is certainly not the worst assumption in the world, consumption is a very different thing from income.  Consumption expenditures are a better measure of material standards of living than income to measure differences in well being.

Data on consumption inequality tends to be scarcer since it’s not reflected on tax returns, but existing studies find consumption inequality to be substantially lower than income inequality. According to a study for the Association of Public Policy Analysis and Management looking, from 1985 to 2010 consumption inequality rose at two-thirds the rate of disposable income, estimating the consumption Gini Index to be below 0.30. Another study by AEI gives similar numbers between 1984 and 2010, showing the average Gini Index for households to be 0.291, while the per-capita index was 0.187. Judging in terms of standards of living, things tend to be much more equal between the rich and the poor than one would initially assume.

Why care about inequality?  So if these are the facts about inequality, what does this imply for public policy? Not everyone agrees.  Inequality is almost always framed as an issue of fairness, so policy will follow that view of “fairness” is adopted.  The disagreement on this is perhaps best shown by the 20th century philosophers John Rawls and Robert Nozick.

According to Rawls, justice depends on society matching principles of liberty and equality. People should be left free in their own private sphere, but any difference in their economic situation is an affront to justice, with a few exceptions.  This world is the most just because any reasonable person would choose it if they were behind a “veil of ignorance” to what their position in that society would actually be.  For Rawls, inequality is an evil in of itself that must be conquered.

Robert Nozick, on the other hand, argued that justice requires looking at history to see if people acted justly, not comparing the outcome to some outcome irrespective of how it got there.  Pattern based theories like Rawls’ not only ignore this, but will be incompatible with a free society.  Even if we achieve Rawls’ ideal egalitarianism, if people are left free to make meaningful choices, it would inevitably lead to meaningfully different results and away from Rawls’ static utopia.  For Nozick, inequality by itself is morally neutral, with its cause determining whether it’s just or unjust.

For either theory, though, it is important to avoid the “fixed pie fallacy.” Only in a centrally planned socialist state is all income piled together before it is distributed.  For a market economy, production and income are inherently linked together.  Income cannot be changed by fiat without dramatically changing how much  income is available in the first place.  As economist Ludwig von Mises put it, “the total available for distribution, the annual product of social labor, is not independent of the manner in which it is divided.” Some having more does not necessarily imply that others have less.

Conclusion. Markets are not a zero-sum game, where one person winning means another person losing.  Economic inequality proves that the rich are winning “too much.”  Ironically, while this is true for government transfers and grants of monopolistic privilege, in voluntary trade people work for the mutual benefit of each other.  While inequality is higher in the United State than other countries, it is not immediately obvious that this implies that there is any “great moral issue” in the first place, especially when the facts and figures surrounding it are so often misapplied.  If the goal is to stop the economy from being “rigged” in favor of the rich, perhaps the solution is to turn our decidedly unfree market into a free one.

Colin Combs is a research associate with the National Center for Policy Analysis.

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